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US homebuilders on shaky ground

Low mortgage rates and strong demand should create a positive outlook for homebuilders, according to Andrey Kuznetsov, Analyst, Hermes Credit. However, specific market and regional risks are undermining the credit prospects for these companies.

Builders wanted: A serious labour shortage in the construction industry has put a dampener on the industry’s margins and growth prospects, despite economic improvements in regions not exposed to the slowdown in the shale oil and gas industry. During the 2009 recession, nearly a quarter of construction workers lost their jobs as the housing market collapsed. There is evidence that a number of labourers are not returning, leaving remaining construction workers overstretched. This lack of qualified labour causes two fundamental problems for the industry. First, the completion rate struggles to keep pace with demand, which is on the rise in the US. Second, margins shrink as workers command much higher pay.

Missing Millenials: One of the most fundamental challenges facing US homebuilders is a reduction in first-time buyer demand. Mounting student debts, lagging wage inflation, scarce financing and lifestyle preferences weigh on the desire of Millenials and Gen-Xers to buy their first homes. While demand for housing is generally rising in the US, the lack of younger buyers could permanently or semi-permanently remove a key driver of demand. For example, 49% of 25-year-olds lived with their parents in 2013, 20% higher than in 1999, dramatically reducing the aggregate number of households even without adding those choosing or having to rent. While overall demand still outstrips supply, this gradual cultural shift is removing some pipeline demand.

Regional risks: Housing-market trends specific to certain US states can also work against homebuilders. Demand for housing in certain parts of Texas, such as Houston, started deteriorating after the oil price dramatically declined in late 2014 and continued to fall throughout the last year. This initially affected more expensive properties, but is now also impacting lower priced homes. In California, where international buyers are usually a significant presence in the market, the stronger US dollar and weakness in buyers’ home economies are deterrents. Additionally, the volatility in equity markets could slow the demand from employees of the historically buoyant tech sector in the state. Homebuilders with above average exposure to these markets are increasingly at risk.

Skewed to the downside: Short housing supply and low mortgage rates – the average 30-year loan charges 3.65% interest - suggest that fundamentals for the sector are strong. However, in an environment where build times are lengthening, margins are under pressure, demand from first-time buyers is declining and certain regional risks are increasing, we think there is more risk to the downside. Furthermore, the sector is trading at a relatively expensive level compared to others, supporting our negative view.

Time to short: Given this balance of risks, we believe that it is prudent to short US homebuilders and have identified KB Home as a business that looks particularly vulnerable. Above average exposure to first-time buyers and to Texas and California are likely to put pressure on its operating performance in the current environment. Smaller builders like KB Home will find it harder to source labour while lower price points will affect their ability to offset margin pressure. Moreover, poor performance by the management team of KB Home, and its ambition to aggressively buy more land this year, which contrasts sharply with the actions of bigger industry players, create more scope for error.

This contentious corporate profile means that the company’s five-year credit default swaps (CDS) present an opportunity. Since KB Home could still scale down its intended land purchases and generate more cash flow if needed, we think that short-term liquidity is strong and believe that the most economic way to express this view is through a curve trade by going long short-term CDS and shorting five-year CDS.

Flip side: We have found one marked exception to our general bearishness on the US homebuilding sector. Toll Brothers is a Philadelphia-based luxury homebuilder which is less affected by the structural issues blighting the rest of the industry. Luxury homes carry higher margins, limiting the impact of high labour costs, while they also generate little to no revenue from first-time buyers. Further, the competition in luxury housing is limited and restricted mainly to smaller companies. While Toll Brothers is exposed to California, we are constructive on its market position within the region and own two of its bonds because of its promising fundamentals.